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Cyprus, bailouts and NGDP targeting

Cyprus has received a bailout from the EU and the IMF. I don’t want to waste my readers’ time on my views on this issue, but I think that Ed Conway got it more or less right. This is from Ed’s blog:

Back in 1941, with the memory of the Great Depression still weighing heavy, an American wrote into the Federal Reserve with an idea. “Would it not be feasible,” the member of the public asked, “to impose a Federal tax on the deposit of funds in bank checking accounts?”

The reply from the Fed was polite but succinct: while there’s no doubt a tax on bank deposits would have “the advantage of administrative simplicity”, it is “not in accord with one of the fundamental principles of taxation in a democracy, namely, that taxes should be imposed in accordance with ability to pay”.

And that, when it comes down to it, is the most scandalous and worrying aspect of the overnight decision to impose a one-off levy on all bank deposits in Cyprus. There is no doubt the country is in big trouble: it was heading for a potential default and is in desperate need of another bail-out. However, trying to recoup some of the cash directly from bank deposits is a step across the financial Rubicon. Even in the depths of the euro crisis, none of the troubled countries had, until now, gone so far as to confiscate bank deposits. As the Fed said all those years ago, doing so involves arbitrary charges on those least equipped to afford them.

And so it will be in Cyprus. If you have anything up to €100,000 in a bank, by the time you next get access to your account on Tuesday (there’s a bank holiday on Monday) some 6.75% of your cash will have disappeared into the Government’s coffers to help keep the country afloat. That goes for everyone, from a pensioner to a small business owner to a millionaire (although Greek depositors get an exception). If you have more than €100,000 the charge is 9.9%.

In exchange, Cypriots will get a share in the relevant bank, equivalent to the value of the tax deduction – although this is unlikely to be of much consolation given the country’s current financial woes.

But why do we continue to debate the terms for bailouts in Europe? Because we got monetary policy terribly wrong. Had we instead had proper monetary policy rules in Europe then we would not have these problems. Let me quote myself on why NGDP targeting has a strict no-bailout clause:

“NGDP targeting would mean that central banks would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bailout clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.”

I am not arguing that Cyprus would not have had problems if the ECB had targeted NGDP, but I am arguing that if the ECB had followed a proper monetary policy rule like NGDP targeting then a banking problem or a sovereign debt problem in Cyprus would never had become an issue for the entire euro area.

8 Comments

Lars,
Libertarian economists need to re-learn the lesson that bank deposits are money and, as such, a contingent liability of the government. If bank deposits are risk assets, then only very large banks in very strong countries will be able to take deposits. The troika has just transformed what had been money (deposits in Club Med banks) into risk assets which require credit analysis. The Fed did this same thing in 1931, and it didn’t turn out too good. Only a fool would now keep money on deposit in any bank (or branch) in Club Med. And by the way, when deposits are redeemed in cash or transferred to foreign banks, M2 declines. This exposes the fallacy of “a single monetary area”.